Beijing’s Balancing Act: Growth vs. Reform

Financial reform in China, experts say, rests on three pillars: decoupling interest rates from government policy, liberalizing the capital account, and internationalizing the renminbi. The three initiatives have been on the government’s agenda since 2012, launched simultaneously under the assumption that each would develop at its own pace.

But the market turmoil of the past six months has raised doubts about Beijing’s commitment to remake financial regulation—and even about its ability to do so—while maintaining a sustainable level of GDP growth. “As seen in recent bouts of equity and currency market volatility and persistent capital outflows, we believe it is more and more difficult for the government to achieve its growth target while steering the economy to a more-balanced structure,” says Marie Diron, senior vice president of credit policy in Hong Kong for rating agency Moody’s Investor Service.

In starker language, international investors wonder whether China can stay on its avowed path toward a more free-market economy. For example, one pillar of reform, internationalization of the renminbi, recently came under pressure when exchange rate volatility widened the trading margin between onshore renminbi, known as CNY, and offshore, or CNH. The central bank’s reaction showed that intervention remains the first response to trouble.

Arbitrage in the offshore market accelerated at the beginning of the year. In early January the spread between CNY and CNH gaped to more than 2%—a record differential that the People’s Bank of China (PBOC) feared was destabilizing the currency. The bank addressed the situation by buying up CNH through state-owned commercial banks, effectively limiting the pool of offshore renminbi available for activities like short-selling. The strategy worked. By January 15, the trading band had contracted to 0.5%, and by the third week of the month, the offshore and onshore exchange rates had converged.

Shortly before they did, the central bank also imposed “normal” reserve requirement ratios (RRRs) on onshore banks with renminbi deposits from offshore banks, without specifying a percentage. Effective January 25, the RRR on such banks ceased to be zero. “Normal” is thought to mean the ratio for banks holding onshore renminbi deposits, currently 17.5% for large institutions and 15.5% for medium-size and small banks.

The PBOC’s moves look to have been successful in stabilizing the currency. But while the smackdown of speculators sends an important message, the central bank was also backing away from the laissez-faire policy it had suggested it would adopt after the IMF decided, on November 30, to include the renminbi in its Special Drawing Rights basket. The bank’s U-turn took some analysts by surprise. HSBC’s senior Asian currency strategist in Hong Kong, Ju Wang, had predicted in December that the PBOC would adopt a more “hands-off” approach to the renminbi after the SDR announcement, reducing its market-smoothing efforts to stem depreciation.

EMBARRASSING CRASH

Besides wrestling with the renminbi, the central bank has been struggling to manage stock volatility. The Chinese market meltdown on the first trading day of the year was the second collapse in six months—and an embarrassment, since the government in December had put fresh measures in place aimed at preventing crashes. As 2016 began, “we had circuit breakers on top of trading limits, limitations on index futures, limitations on market lending activities and also on margin trading,” says Bank of Communications chief strategist Hao Hong. “Yet with all these policies in place, we have more volatility, not less.”

In response, China’s cabinet created a new department to coordinate financial and economic affairs. And separately, the central bank announced it would use commercial banks’ reserve requirement ratio, previously deployed to inject liquidity into the financial system, as a tool for enforcing financial stability instead. Some experts greeted the move with skepticism. “Banks are still expected to support policy objectives and align their strategies with the state’s broad economic goals,” wrote Katie Chen, a Beijing analyst at ratings agency Fitch, in a recent note. “That suggests China remains a centrally controlled economy despite financial reforms.” The latter, Chen continued, had suggested the government would give market forces a bigger role.

Although her caution is understandable, recent events could signal better regulation in the future. The People’s Bank of China itself appears to be gaining a steadier grip on policy. Its new RRR rule “could be good news for financial reforms in China, as the PBOC has traditionally been a stronger proponent for reforms, compared to the China Banking Regulatory Commission and the China Securities Regulatory Commission,” says Xia Le, chief economist for Asia at Banco Bilbao Vizcaya Argentaria (BBVA) in Hong Kong.